If you’re looking for the sectors of the stock market set to perform the best in 2018, a good place to start is those sectors that performed the worst in 2017.
Though that flies in the face of rational, reasoned investing, it’s produced outstanding results over the past 10 years. Markets and economies move in cycles. And so do sectors within a market – in a way that’s more predictable than you might think.
Two years ago, we found that an Asia investment strategy of buying the worst-performing sector of the year at the beginning of the following year – and then holding it for 12 months – resulted in an annual average return that was more than double the return of the index.
We tested the strategy again last year, with similar results. For both tests, we used the Bloomberg World Asia-Pacific Index, which is made up of over 2,600 stocks listed on stock markets throughout Asia. The strategy suggested that Asia’s utilities and health care sectors – the worst-performing sectors in 2016, falling both 9 percent – would do well in 2017.
How did it do? Mixed. Health care returned an annual average of 28 percent and was the third-best performing sector (out of 10) in 2017. That was 2 percentage points higher than the index’s return of 26 percent.
Meanwhile, utilities (the other biggest loser in 2016) only delivered a 14 percent return in 2017 – and it was the second-worst performing sector for the year. It underperformed the overall index’s return by 12 percentage points.
What does the strategy say for 2018?
Avoid a common investment pitfall through rotating sectors
As an investor, it’s easy to follow the herd and buy the stock that’s been rising for a long time – because it feels like it’s going to continue to rise. This is called the status quo bias, which is when we tend to think that things are going to remain the same – because our most recent memory is of them being a certain way. Investors buy a stock that’s been steadily rising in price because they expect it to continue going up. Investors expect a bull market to continue because, well, the market has recently been rising.
But markets are like seasons; they move in cycles. They rise and then they fall, and then they do it all again. Just as you wouldn’t buy shorts as autumn approaches (even though everyone else has been buying shorts all summer), you shouldn’t buy into a sector just because it’s been going up for a while.
This is how to rotate your sectors
Sectors of the stock market do better, or worse, each year as their component stocks rise, or fall. The chart below shows the performance for each sector of the Bloomberg World Asia-Pacific Index by year.
Each year’s best-performing sector is highlighted in green, while the worst-performing sector is highlighted in red (the overall index’s performance is the first row). So, for example, in 2014, the index rose 11 percent, while the consumer discretionary sector was the market’s worst performer, with a 3 percent decline. The financial sector was the best, with a 23 percent gain.
One thing that’s clear is that the best performers don’t stay on top for long – and there’s a lot of movement between the best- and worst-performing sectors. In a number of years – for example, 2008, 2009, 2014 and 2016 – the year’s best-performing sector was the previous year’s worst-performing sector, or vice-versa.
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Use this sector rotation strategy
We back-tested this strategy for Asia’s stock market sectors: Buy the worst-performing sector of the year at the beginning of the following year (for example, buy the worst-performing sector of 2009 as of the first day of trading of 2010), and hold it for a year. Do the same thing at the beginning of the following year, and so on.
As I mentioned earlier, the strategy in 2017 didn’t work that well. But as shown in the graph below, over the past 10 years, it’s outperformed the Bloomberg World Asia-Pacific Index by a huge margin: It’s generated an average annual return of 10 percent, compared to 4 percent for the index.
So what does this mean for 2018?
The worst-performing sector in the Bloomberg World Asia Pacific Index in 2017 was the telecommunications sector. It was down 9 percent, compared to the 26 percent increase in the index (and a 45 percent return for information technology, the index’s best-performing sector).
Does this mean that the telecommunication sector in Asia will perform well this year? Perhaps. History shows that investing in last year’s poorly performing sectors generally makes sense. But if you want to follow this strategy, there unfortunately aren’t any easy ETFs to use to invest in the sector. However, it would be possible to replicate nearly 60 percent of the index “by hand” through the five largest constituents of the sector index, as shown below.
Publisher, Stansberry Churchouse Research